Arnold Kling  

Modern Finance vs. Portfolio Balance Theory

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The first chapter of the Macro Doubtbook definitely needs a section on the relationship between finance theory and macroeconomics. I think that relationship is an uneasy one.

Macroeconomists use what is called "portfolio balance theory" to argue that changes of the relative supplies of securities matter. Modern finance, instead, uses variations on the Modigliani-Miller theorem to argue that changes in the relative supplies of securities do not matter.

In portfolio balance theory, if a firm issues equity to extinguish debt, this disturbs the balance in investors' portfolios. At the previous prices, they now have too much equity and too little debt, so they bid up the price of bonds and bid down the value of stocks in the capital markets as a whole..

In Modigliani-Miller, investors do not care about the firm's financial structure. They know the risk of the projects that the firm is financing. The financial structure redistributes the risk, but it does not change it. The overall market for stocks and bonds is unaffected by the firm's change in financial structure.

Christopher J. Neely has a paper that argues, using event studies, that when the Fed announced plans to purchase long-term assets, such as mortgage bonds, this raised the price of long-term bonds, both here and overseas. I trust that empirical work. However, he argues that the change in asset prices comes from a portfolio balance effect. There, I have a problem.

First, the Fed clearly indicated that these purchases were temporary. From the beginning, there has been much discussion of an "exit strategy." So, the private sector knows that these securities are coming back into the market at some point. Moreover, even if the Fed is picking up some of the risk, that risk does not dissolve into thin air. It gets spread among taxpayers. One could make a Ricardian equivalence argument that people realize that their risk has not gone away.

To me, it seems that finance theory wants to pull in the direction of Fed impotence. But macroeconomists do not want to confront that. As far as I know, Fischer Black is the only economist who has attempted to reconcile macro with finance, and the result was a very unusual take on macro.

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COMMENTS (7 to date)
Jfox writes:

Well wait a second. Modigliani-Miller is only a theory, a way of looking at the world. It is very useful for describing and deriving a lot of things in finance, such as theoretical returns of stocks and bonds, optimal captial structures, etc. But M&M is based on a number of assumptions, many of which probably aren't true in the real world. For example, one assumption underlying M&M is efficient markets. I for one do not believe markets are efficient. M&M also assumes that there is no "signalling" implied by the issuance of securities. M&M makes very crude assumptions regarding the effect of income taxes, both at the corporate level and the individual level. There are other such simplifying assumptions made in order to make M&M useful. I think M&M was intended to draw equivalency between securities of various types, i.e., debt and equity. But most practitioners I think realize it has significant practical limitations

Arnold Kling writes:

jFox, you are correct that MM is only a theory, and in fact it probably does not hold in the real world. Still, you would think that somebody would be focused on the inconsistency. Hundreds of papers have been written trying to figure out how to tweak microeconomics to yield macroeconomic results. You would think that someone would be trying to do that with finance theory.

Jfox writes:

That's interesting. I didn't realize that there were no papers on this subject. It does seem like an obvious candidate. It may be, and I'm only speculating here, that it is difficult to try and connect these 2 empirically. I'm just guessing here. I'm not in academia and have little idea what subjects are being addressed in research

Jfox writes:

.....Or that, at most universities, the departments of economics and finance are relatively isolated from each other

Norman writes:

"One could make a Ricardian equivalence argument that people realize that their risk has not gone away."

One could, but given how little empirical support there is for Ricardian equivalence, one probably wouldn't want to.

I think macroeconomists resist the idea of an impotent Fed because there is so much empirical evidence, like Neely's, that indicates the Fed's actions are frequently associated with noticeable effects. Perhaps portfolio balance isn't a very good explanation for the correlation, but then ignoring the evidence isn't either.

caveat bettor writes:

Arnold: In referring to Fischer Black, do you mean his view that monetary authority has no influence on the prevailing interest rates?

Noah Yetter writes:
In Modigliani-Miller, investors do not care about the firm's financial structure. They know the risk of the projects that the firm is financing.
Seriously? Seems like a good reason for dismissing Modigliani-Miller altogether. NO ONE knows the risk of the projects the firm is financing. Not investors, not executives, not management, not laborers. Risk of this sort is not only unknown it is unknowable.
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